Summary

• The oil services industry faces strong headwinds.
• Almost all offshore drillers have had oils decline fully priced in, trade at huge discounts to BV.
• Seadrill operates one of the highest-quality rig fleets in its peer group.

I have mixed feelings about Seadrill (NYSE:SDRL ). I came across the company by accident, while I was originally looking at Paragon Offshore, which tanked after Noble Energy spun it off as an independent driller primarily owning offshore jack-up rigs. Its main issue was fleet age. Although the company’s rigs had undergone considerable life extension upgrades and maintenance over the years, there was concern over how much longer and how desirable those rigs would be. Seadrill popped up on my radar while I was looking at offshore driller comps and noticed that it too traded at an extremely low multiple. But the more I looked into the company, the greater the opportunity seemed to me. Its fleet quality is pretty much a polar opposite to Paragon’s; it rigs are high-spec versus Paragon’s standard-spec models, and the company operates one of the most modern and high-quality fleets in the offshore business. After crude prices collapsed, O&G drillers got hit pretty hard, and I took a closer look at Seadrill in the hopes of finding a bargain.

The general thesis here is good business at a value price, not great business at a fair price, so the discussion will revolve less around franchise value/competitive advantage/barriers to entry and more on macro direction and why the company shouldn’t be trading at liquidation value. I’ve split the discussion into three parts: (1) Macro, (2) Relative Valuation and (3) Fundamental Valuation.

(1) Macroeconomic Headwinds

The Oil & Gas Services group, specifically O&G Drilling, has historically reacted in a very cyclical fashion to oil price movements. This is because drillers find the demand for their drilling rigs in capital spending budgets of upstream Exploration & Production companies. In high oil price environments, E&P companies find it economic to drill more expensive wells (such as ultra-deepwater or oil sands, see chart below), and hence, demand for rigs is moved the more exploration and production is going on. In lower oil price environments like today’s, the economic viability of many of the O&G plays made with $100/bbl crude in mind will be challenged, and hence, E&P firms will either take uneconomic wells offline or focus more on the low-risk option of developing on-hand reserves as opposed to the higher-risk option of searching and drilling for new resources (i.e. less E and more P).

Source: Bloomberg

(Note: Index is a market cap-weighted group of peers shown in the peer group table below. The top four largest by market cap make up 77% of the index weight, SDRL makes up 17% of the index.)

The Oil & Gas Drilling group is a highly commoditized industry. Almost anyone with the money to do so can buy a few rigs and a trained crew and contract them out. There will be intangible costs, such as building up a reputation as a good operator, but that goes for almost every business in the world, and it’s achievable. What I mean to say is that rig owner/operators are a no-moat business. I don’t see anything in particular that would give any one driller a huge unattainable advantage over the next.

Thus, to form an opinion on an oil services company, one needs to take a view on oil prices (indirect input) and on dayrates (direct input). These are the key drivers for the profitability and growth of the business, and because no real moat exists, they matter a lot.

Price of Oil

Seadrill was already down

50% before the oil price collapse in late November last year, and suffered another

50% decline when oil began to fall. Oil at $50 has some serious ramifications across the board. I think oil at $50 seriously threatens the long-term demand for offshore rigs, and consequently pushes dayrates down significantly. So there are two scenarios that merit attention: 1. Oil recovers at some time as supply and demand come back into balance 2. Oil remains at $50 for some considerable stretch.

On scenario 1, my opinion is that a 50% drop in oil prices after experiencing a high oil price environment for the past four years will inevitably affect the supply side. All the fields to the top right of the cost curve who saw it profitable to produce at $50, $60, $70 $80 and even $90 are essentially wipeouts, and if it’s not economic to produce, I don’t see any reason they will, especially when any futures contracts these producers have begin to expire. The real question I feel is when supply and demand come back into balance. Most analysts say production cuts will happen over a four-quarter period, and forecast a rocky 2015 and 2016 for oil. (Disclosure: These are the same analysts that saw oil at $90 and $100 a few months ago, so take forecasts with a grain of salt, or just ignore entirely). Anyway, without trying to pinpoint oil in 2015 or 2016, I’ll just say that generally I expect $50 crude to take enough supply off the market to lift prices in the medium term.

On scenario 2, for the reasons described above, I think this has a lower probability of occurring. I guess Saudi Arabia could really destabilize prices, because they’re the ones with the largest spare production capacity, and they’re also the ones who wanted to stress test shale in the first place. With foreign reserves at around US$750bn and sovereign wealth fund assets of a roughly equal amount, they (along with the rest of the GCC) have the safety net to not cut spending and fund fiscal deficits in the near term; but medium- to long-term, low oil prices will threaten their financial position.

Ultimately, debating the direction of oil prices is a whole other topic on its own. So I’ll assume oil will be bearish and unpredictable over the short term, but repricing to higher levels when production begins to go off-line over the next year.

Dayrates

As shown below, Seadrill relies primarily on its floaters as revenue generators as of September 2014’s fleet status update.